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The Illusion of Alignment in Investing

The illusion of alignment, or: How I came to own Megadog

It’s really hard to design incentive programs that tie individuals’ actions to organizational success.

Take it from me just how hard it is: I’m a guy who just rewarded his children with a dog, literally, for getting 500 stars on their behavior chart. This dog — formally named Megadog by my five-year-old daughter — was the maximum bonus possible in a kid-compensation scheme gone awry. There were smaller prizes, but the dog was the stretch goal, a lottery ticket promising riches but almost impossible to achieve.

I realized too late that I failed to sufficiently define what each star represented (i.e., my kids’ actions). I also failed to determine how those stars tied into our family’s success. I even failed to appreciate the power of the chart itself. For example, I included a “star claw back” for bad behavior — a device I expected would extend the runway of this little experiment. In practice, however, taking a star away from a kid was so emotionally devastating that it became akin to employing a nuclear device: You could talk about using it, but you never actually did it.

And so, we ended up in an escalation of commitments, which ultimately led to this puppy dog at my feet as I write these words. Anyway, you’re probably wondering how Megadog fits into a column about Giant investment organizations. Simple: Every time I see this dog, I am reminded of just how hard it is to design an effective, long-term incentive program. It’s very hard. But that’s exactly what many of the Giants I work with are attempting to do.

“Alignment” is the new buzzword; it has replaced “insourcing” and “privileged access” as the key motivators for this generation of investors. Wherever you see innovation today — seeding mangers, new technologies, new capabilities — you’re seeing an attempt by Giants to align their interests with their ultimate investors. But with this new focus on alignment comes a renewed focus on internal and external compensation structures that can actually implement the theoretical alignment in practice. They may not be resorting to star charts, yet, but they are trying some new and creative things.

The problem is that most investment organizations are like my family: They have murky definitions for organizational success, which means their incentive programs are being designed without a clear picture of the end goal.

I’ve heard the idea of success defined in many different ways. Some say investment performance is the best indicator of success — recognizing that market- and peer-based benchmarks are blunt instruments that encourage short-termism. Some say success is delivering retirement security to millions of people — but they then struggle to indicate how this goal helps guide operations. Some say that success is never increasing member contributions — but they acknowledge that this success factor leads to unappreciated risks. Some funds even directed me to their compensation plans, suggesting that higher compensation meant they were a better investment organization.

In only a handful of cases have I met investment teams that are able to define, in ways that can be made fully operational, what organizational success looks like, how to measure it, and, in turn, which incentives would promote that success. Coherence among those three factors is rare. But it’s required.

Many organizations confuse their ultimate success with their metrics (peer performance or value-add against a benchmark) and their means (compensation plans, deal flow, fees saved). For example, it’s ludicrous for university endowments to judge their success based on a comparison with their admissions competitors, as if they are in a sort of sports league — but it’s very common.

With this new focus on alignment, Giants will have to spend a great deal of time scrutinizing their own organizations. Each fund is inevitably going to have different objectives and goals. The key is to clearly understand what your fund sees as success. Is it a lofty goal to pay a pension, support a university, or facilitate inter-generational equity? With a clear definition of success now firmly in mind, and agreed upon, you can begin to consider metrics upon which you will judge that success. It’s at this point you can design compensation plans that use these metrics to achieve the success you’ve defined.

I can still remember describing to my wife the genius of my chart: I said that even in the unlikely event of chart completion, which would require a level maturity from my kids that even I barely possess, it would signal the kids were ready to care for a dog. But, I ask with hindsight, when did caring for animals become linked with my family’s success? All I wanted were kids who were respectful and active listeners. I admit I lost sight of the idea of aligned success. I confused the metrics. And I designed a faulty incentive program. 

Today, I have two kids that are barely, if at all, better listeners than when we started this. And I have a dog. So, take it from me: If you don’t know exactly what you’re trying to achieve, how you measure success, over what time horizon you’re measuring it, and how your incentive programs tie all those factors together, then you, too, will likely end up with a few Megadogs walking around your office.

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